Sunday, November 7, 2010

Fixed Income Outlook
■ What slowdown?: Corporate sentiment in top form
■ What You Will: Fed tries not to disappoint
■ Moral ceiling: Periphery continues to set the tone
■ Greek municipal elections of lasting importance

What slowdown?
The world’s two most important countries relived what the PMIs in the eurozone had already celebrated two weeks ago, namely a satisfactory and above all better-than-expected performance in light of the prophecies of doom about a strong slowdown in growth. The PMI in China rose from 53.8 to 54.7 and in the US from 54.4 to 56.9. Together with the also higher PMI reading in the US services sector, this was really an impulse that should for the time being silence the discussion of a double dip recession in the US.

The reaction to the data - at least on the bond market - was, however, again very manageable, this time however because of the US central bank's decision that had been avidly awaited for weeks.

What You Will
Ultimately, what the US central bank offered was, however, also manageable. In fact, the Fed’s primary objective appeared to be not to disappoint market participants too much. This was already indicated at the end of last week when the US central bank conducted a poll among its primary dealer banks on the expected volume and possible reaction. The volume ultimately announced was then correspondingly unspectacular.

By the end of 2Q11, the US central bank plans to purchase USD 600bn of Treasuries (roughly USD 75bn per month) and to reinvest a further USD 250-300bn in principal payments from maturing securities holdings and interest income from asset-backed securities. According to the Fed, 80% of the purchases will concentrate on the 2.5-10Y maturity segment. The reaction remained manageable, with yields pulling back slightly in maturities up to 10 years. The only disappointment was at the ultra-long end, where there were steep losses in the 30Y segment. Overall, the expectation - above all there - had been for higher volumes. The reason why there was, however, no euphoria at the short end either, despite the fact that the volume was slightly above consensus expectations (USD 500bn), was the manageable changes to the written risk assessment. Here, the Fed dashed all hopes of creativity. In fact, the old core sentence "... are likely to warrant exceptionally low levels for the federal funds rate for an extended period" was repeated. Equity markets were not overly impressed either, with minimal gains of less than 1%, nor was the USD Index with slight losses of 0.3%. What remains therefore is no groundbreaking new insights, especially since the Fed naturally retained the option to review the volume of the program at any time in the light of new information.

That means than on an unexpected improvement on the labor market and/or a clear rise in inflation expectations the program can be cut back; equally, if the opposite is the case, the program can also be expanded.

Moral ceiling broken
To what extent was this development interesting in Europe? Not very, to not at all. On the money market, the slow and extensively linear rise in rates continued. At the long end, the skittishness about the periphery countries was the sole dominant factor.

That leaves home-made problems within the individual countries and the fall-out from the overarching political discussion of the "orderly state insolvency process", which poisoned the climate and drove Irish bonds through the "morally" acceptable ceiling (defined by the Greek costs for availability of the EUR 111bn rescue package). Once again, policymakers must concede that Trichet’s warning about such a solution was more than justified, and the ECB will have to face the music. It will at any rate be interesting to see to what extent the ECB prevented Irish yields from exploding this week via purchases of government bonds, and it would of course be even more interesting to learn what percentage of the market capitalization of Irish government bonds the ECB already has on its books.

Bottom up: Not G20, a municipal electionis the decisive factor
The overriding topic of the coming week is the G-20 meeting of the heads of state and government and the question how it will handle the topic of current account imbalances as the key factor in the "currency war".

This will, in contrast, leave the domestic bond market cold. Here, the key item on the agenda is a municipal election. According to the Greek Prime Minister Papandreou, a defeat for his ruling Socialist Party at the municipal elections at the weekend could trigger parliamentary elections as early as December. Papandreou did not, however, give a numeral target from which an election disaster would result in such a serious move. It is fairly safe to assume that one or another head of government will reach for the phone on Sunday to dissuade Papandreou if necessary from this reckless move. A renewed wave of massively rising spread volatility would ultimately be the inevitable consequence, and not only for Greek government bonds.
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